The appeal of downside protection can't be denied. Because hedge funds use strategies that differ drastically from long-only equity investing, they produce results that are quite different from what the market dishes out. In 2008, for example, the Standard & Poor's 500 lost 38 percent of its value and the Dow Jones fell by 34 percent, but the average hedge was down by only 18 percent. Including hedge funds in a year like that could buoy portfolios and produce above-average results.
"They offer a unique return source than what you get from growth and value stocks," Icten explained.
How do they do it?
There are a number of strategies. One of the most popular is long-short. The long/short strategy is a method of investing that involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value
Another popular style is merger arbitrage, which invests in companies that have announced a merger or acquisition. These funds are wagering that the merger will be completed in the time frame spelled out in the original announcement and at the price agreed to by management. But a lot can go wrong until the final deal is completed.
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"You get paid for taking on the risk that the deal may not close," Icten said. "There are risks that come up around antitrust issues that may derail the deal or that the [Department of Justice] might stop the deal from completing.
"Those risks are totally different than what you get in the stock market."
Recently, activist funds have overtaken others as the most popular of hedge fund strategies, reports eVestment, a research firm that compiles data on the hedge fund industry. These funds buy up large ownership stakes of companies and then try to influence management to cut costs and approve larger dividend- and share-buyback programs, all in the interest of increasing the companies' share prices.
Because of the low correlations between hedge funds and other investments, Carol Schleif, deputy chief investment officer of Wells Fargo's high-net-worth unit, Abbot Downing, recommends a 10 percent to 40 percent allocation to hedge funds for Abbot Downing's clients with a moderate risk tolerance.
"You would want a higher allocation in a moderate portfolio than an aggressive portfolio, because you're trying to smooth out day-to-day volatility," she said.